Solid Employment Report Strengthens Resolve Of Fed Hawks

The BLS came out with a solid employment report today. In June, the economy added 222,000 jobs, far above the consensus forecast of around 170,000. In addition, the April and May numbers were revised upwards by 47,000. The average hourly earnings were also up by 4 cents, making that a gain of 2.5% over the last year which is slightly higher than inflation. The unemployment rate ticked up to 4.4% while both the participation rate and employment-population ratio also increased.

This report should be music to the ears of the Fed members who are determined to raise rates. That viewpoint was under pressure after recent poor unemployment numbers and falling inflation and other FOMC members were beginning to question the pace of rate hikes and even the intention to start unwinding the Fed balance sheet later in the year.

On the other hand, it was not all bad news for the doves. The uptick in the unemployment rate and growing participation implies that there is still some more slack in the labor market. And the even the increase in average hourly earnings, while holding steady from last month, has been falling since the start of the year. Lastly, just like it seems there is a constant data problem with first quarter GDP, there also seems to be an issue with June employment reports. As Bill McBride notes, "This is the 4th consecutive solid job gain in June:  304 thousand in June 2014, 206 in June 2015, 297 thousand in June 2016, and now 222 thousand in June 2017."

As we have noted, the Fed inflation forecasts have overstated reality for the last eight years and even today they don't expect inflation to rise beyond 2.2% in the next two years. And, while the inflation projections have been just plain wrong, Tim Duy now believes the Fed is making up its unemployment projections, essentially reverse engineering the number to match their plans for forthcoming rate hikes. The Fed expects GDP growth to exceed long-run potential growth by about .4% this year, implying a further drop in the unemployment rate. In addition, the Fed is not expecting any large increases in the participation rate which might offset those implied employment gains from GDP growth in the unemployment rate. Yet the Fed forecast shows unemployment holding steady at 4.3% for the remainder of the year.

Says Duy, "What I don’t like is the feeling that the Fed’s unemployment rate forecast is essentially being reverse-engineered. They have a rate forecast that delivers policy normalization in a time frame they think appropriate. And they have a reaction function. If policy makers forecast lower unemployment then they need to either adjust the reaction function or lower their estimate of the natural rate of unemployment more aggressively. They don’t want to do either.  So to keep their rate forecast intact, they need to set a matching unemployment rate forecast. And that produces a flat unemployment rate for this year."

This has serious policy implications, as Duy makes clear. If the Fed's other projections about inflation, which are admittedly optimistic, and the participation rate are correct, then the unemployment rate will continue to drop further. As it drops, the pressure from the hawks on the FOMC to raise rates at an even brisker rate will continue to grow. Again Duy, "Ultimately, the Fed sees the risks associated with undershooting the natural rate of unemployment as greater than those of low inflation. What this means is that the Fed will not turn dovish easily. Officials will not take their rate hike plans and go quietly into the night, even in the face of low inflation".

So we are left in a strange place where a falling unemployment rate and, presumably, higher hourly wages will create a push for increased rate hikes, despite low inflation, and, at the same time, any uptick in inflation will also create the same reaction. Once again, it seems, the Fed is determined to take the punch bowl away before the party even begins.